With the continuing cap rate compression we have seen over the past couple years, I am often asked if a triple-net-leased property is a smart investment. This decision should not be made based on cap rate alone when in reality there are many factors to consider in determining whether a net-leased commercial asset will create a favorable equity return. As with any investment, it is always in the buyer’s best interest to work with an advisor who is knowledgeable about the specific asset class of interest and has a proven record of success in dealing with the intricacies associated with that type of transaction. A seasoned advisor familiar with net-leased properties will be able to factor in all the components at work specific to that property and assess the potential risk and return of that venture.
The Capitalization Rate
The cap or capitalization rate is calculated by dividing the annual Net OperatingIncome (NOI) by the cost or value of the property. For example, a $5,000,000 property with a $500,000 NOI would produce a cap rate of 10%.
Commercial real estate advisors use the cap rate to determine the equity return on an asset, as well as a simplified metric for comparing like investment opportunities. The cap rate’s influence in a buying decision is weightier when dealing with a 100% cash purchase and in this instance, the investor would be looking at a 10% equity return on their investment. In contrast, those investors financing a property need to consider additional factors when analyzing a potential investment in a net-leased commercial property including the loan interest rate, and the purchase price for the specific market of the property in question, as well as its growth potential over time. Most investors purchase property with the expectation that the NOI will increase over time, generating more profit, and improving the overall value of the property.
Perceptive Investors Capitalizing On The Perfect Storm
Despite the falling cap rates, savvy investors continue to flock toward NNN leased investment properties, as they are aware of the opportunity presented by the overall impact of other key elements at play in this type of transaction, such as follows.
- Compressing cap rates may indicate a specific market is heating up and therefore may be a favorable investment, one that will produce a greater return over time.
- Lower cap rates may indicate that a property holds lower risk and is more likely to have guaranteed or institutional funding.
- Current interest rates are very low.
Right now, though cap rates are low, interest rates are also at a historic low, so for an investor financing a property, these two variables play a significant role in the overall investment outlook. While there are several elements that need to be analyzed with proper due diligence, let us look at a simplified scenario using only these two bases.
As you can see, though Property A has a higher cap rate than property B, Property B will produce a greater equity return on investment when factoring in the interest rate of the commercial loan on the property. This is only one example of how one small variable can significantly impact the outlook for a particular investment. While net-leased properties remain a favorite among investors for their low-maintenance management requirement along with their consistent income stream and multitude of tax advantages, they are complex investments that require thorough due diligence by an experienced advisor.
Interested in learning more about Net Operating Income (NOI)? Check out this updated post by FitSmallBusiness.com on how NOI is important, and the pros and cons of using NOI to analyze the value and profitability of a commercial property.